Thursday, March 4, 2010

Hugh Hendry Continues to Doubt China

There was once a time I had cornered the Hugh Hendry market in the financial blogosphere but in the past year and a half he has become quite the star, most likely for reasons that first attracted me to him.  Right or wrong, he is eloquent, witty and blunt - sort of crossing Simon Cowell with Dennis Miller. It's been nearly half a year since we last checked in with him, and 2009 was not quite so kind as 2008 was to his investments.  But as Keynes once said: "the desperate central bank printing press can remain irrational far longer than you can remain solvent".... or something like that.

Below (article from a few weeks ago) we have further thoughts on a theme Hendry advanced in 2009 [Apr 16, 2009: Hugh Hendry, Citiwire Interview], and others (like Jim Chanos) have jumped on board of late - that China has some major issues of its own, and the group think that tends to dominate investors once they latch onto a theory has now infected them when it comes to this country.  I too have raised concerns about what the eventual effects will be of a once in a lifetime amount of loan growth seen in 1st half 2009 in the country - both when the policies were really just getting off the ground [Feb 16 2009: Is China Pulling an Alan Greenspan?] and a few months later.  [May 27, 2009: How is China Spending Their Stimulus? ... and How Many Loans will go Bad?]   I still think, as professed last year, it might take until 2011-2013 before we see the malinvestment come home to roost. Perhaps this early identification of a problem that some of the 'best and brightest' in the investment field (with armies of CFAs and PhDs) are now coming around to, qualifies me to work for Chanos whose team came to the conclusion half a year after me? ;)   Nah, I don't have the right pedigree.... I'm just a hick who writes funny financial stories on the interwebs, in between staring at the wall while thinking of all the miracles happening across the global economy.

Anyhow, back to Hugh.  I always prefer my dose of Hendry in video over the written word, because it's just hard to do his type of 'snarky' on paper... but all we have are words for now.  Via the UK Telegraph:
  • Robert Prechter, the eminent American observer of social and economic trends, wryly contends that stock markets usually deceive those people who argue for outcomes based on seemingly logical causation.   Could our professional money managers' infatuation with China prove similarly unrewarding? China's economy is certainly on a tear; economic growth has averaged 9pc a year over the past 10 years, compared with a paltry 1.9pc for the British economy. Last year, despite the credit crunch, China posted a remarkable growth rate of 10.7pc against a British contraction of 3.2pc. This is impressive stuff.
  • The spell cast by a contemporary cult is undoubtedly hard to resist and some brave souls, willing no doubt to extrapolate present trends forward, are even proclaiming that China will usurp the United States as the world's largest economy. Goldman Sachs' chief global economist, Jim O'Neill, even taunts the naysayers, saying, "You either get it or you don't." Such is his conviction.
  • However, the composition of China's growth has undergone a potentially treacherous change: in the absence of expanding foreign demand for its exports, it has instead come to rely on a massive surge in domestic bank lending to fuel its growth rate.  Indeed, when measured relative to the size of its economy, the 27pc point jump in bank loans to GDP is unprecedented; at no point in history has a nation ever attempted such an incredible increase in state-directed bank lending.
  • What a turnaround: from an export juggernaut to a credit addict. Who would have thought it necessary back in 2001, the year everything all started to work out for China?  That was the year the Chinese gained entry into the World Trade Organisation. The ascension to the WTO also coincided with the American Federal Reserve's loose monetary policy response in the aftermath of the NASDAQ crash. Exports surged, especially to the US, and China's current account surplus increased from a modest 2pc of its economy to a monumental 11pc, all by 2007.
  • This appetite for cheap Chinese exports, which had at one point seemed insatiable, means that we in the West have come to owe our largest Asian trading partner quite a hefty sum of money. China has become the world's biggest creditor, after amassing nearly $2.3 trillion of foreign exchange claims on us. However, the spectre of a creditor nation running persistent trade surpluses has ominous historical portents. It has happened only twice before, with the US economy in the Twenties and with the Japanese economy in the Eighties.   (and what happened next Hugh? Oh goody - I love a good suspense novel)
  • Economics is a cruel master and in both of the previous examples a failure to allow exchange rates to adjust to the new reality created a large speculative pool of credit that, in turn, led to overvalued domestic assets and, eventually, an economic crisis. Never forget that in economics, first can become last.
  • The China bulls assure us that this time it is different. (It's always different this time - just ask CNBC) Yes, the banks are lending money at breakneck speed, but look at what they are doing with it!   [Nov 13, 2009: Ordos - China's Empty City]  They suggest a new era reminiscent of Protestant Capitalism. They want us to believe the atheist Chinese are prepared to work harder and defer their gratification for longer.
  • Undoubtedly, China's state planners have favoured investment over consumption. High-speed rail networks, first-class infrastructure projects and the urban migration of 55 million people every year are common explanations for the ability of the nimble Chinese to overcome the frailties of this global economy. But can too much of a good thing be bad for you? The goal of economic policy, after all, is to maximise households' wellbeing and consumption. Unfortunately, unlike in most countries, China's share of consumption within its economy has fallen relentlessly, reaching 35pc of GDP in 2008. Something isn't right.
  • The ancient ethical system of Confucius is silent on the subject of modernisation. There is no proverb counselling that "wise men not invest in over-capacity". Perhaps there should be: in China, investment spending has tripled since 2001 and the consequences are staggering. A country that represents just 7pc of global GDP is now responsible for 30pc of global aluminum consumption, 47pc of global steel consumption and 40pc of global copper consumption. The overriding problem is that the Chinese model leads to a deflationary spiral that is perpetual in nature. Domestic consumption never grows fast enough to absorb the supply, prompting the planners to commit to ever-higher levels of investment. Over-capacity inevitably plagues many sectors of the economy and Chinese profitability is already low.
  • Remember, it is one thing to create economic growth, but it is another thing to truly create wealth. If I commit to building a new commercial property in Shanghai I will undoubtedly contribute to GDP growth. However, if I have no tenants and the city already has a vacancy rate of 20pc, then I am probably destroying wealth. (bingo - perhaps Hendry could explain this to those in this country who are addicts to GDP as a measure of national health; one of the country's greatest dogma's in fact)
  • Adam Smith taught us that real wealth comes not from piles of gold or their modern-day equivalent, the foreign exchange reserves amassed from a profitless succession of current account surpluses.  Rather, Smith suggests that real wealth is founded on the skills and productivity of a country's citizens. This is the central concern regarding the sustainability of the Asian economic model. Power without profit can prove ephemeral. This is an axiom the Japanese are all too familiar with. We cannot say we have not been warned.
Even if Mr. Hendry is correct, as with all things in the markets it doesn't matter until it matters.  Just as "it was different this time" with those wacky internet stocks in 1999, and US real estate in 2005-2006 -  the reality behind those situations did not matter ... until they did.  Most likely when the all but the most ardent doubters of China are convinced, will the curtain be drawn back.  Until then... as the lavishly compensated former CEO of Citigroup, Chuck "no clawbacks here!" Prince advises... we dance.

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